Common pitfalls in trading options!

If you read my previous articles, you may be confused why there are so many people still losing money if trading options can be very conservative. Let me compile a list of contributing factors of losing money in trading options.

1. Buying out of money options with short day to maturity
This is indeed a speculation. Imagine this, Apple share is trading at $120 now and we open an options position we wish that the share price to hit $150 in 1 month. We pay $0.30 for every options we purchase and happily wait for the Apple share price to shoot up. Unfortunately, this type of trade seldom success. We are expecting Apple to go up 25% ([150-120]/120) in a month, if we project it to a year, we are expecting 300% rise! If after 1 month, the Apple share does rise sharply and end up at $150, we are still losing all our money. We will only start making money when Apple share goes beyond $150.30 (Remember the $0.30 options price that we have paid?). So, this is a very low probability of success trade.2. Over-magnifying the power of Call Options
Continue from #1, if we are too indulged with the thinking of putting small money in our account to make big money in a short period of time, we may scale up the number of options that we want to purchase. Instead of paying $30 ($0.30 *100units) to buy 1 options, we increase the number of options to 100 options and hoping that the Apple shares will sky-rocketing before the options expired. If the Apple shares reaches $200, we will be making $497,000 ([$200share price – $150strike – $0.3premium] * 100options * 100units] in a month! An astounding result? Again, do assess the probability of success.3. Over-leveraging options trading
Imagine we have identified Starbucks as a great value stock that is currently trading at $63. Instead of buying the stock directly, we sell an options, with the intention to buy the stock if it goes below $61 in a month time. As an options seller, we are paid with $1 for every options that we sell. It looks great so far. After a month, assume the Starbucks share price trades at $62, we will be happily pocketed $100 as 1 options represent 100 units. After a few rounds of not converting to stocks, we may be greedy now. Instead of 1 options, we now want to sell 10 options to collect $1000. Here’s the problem now. If Starbucks drops to $55 (using the same example) on maturity date, we are obliged to buy the stock now. As we sold 10 options, we need to buy 1000 units of Starbucks (10 options * 100units), which means we need to have $60,000 ([$61strike-$1premium]*1,000units). If our account does not have sufficient cash to buy $60,000 worth of Starbucks, the brokers will liquidate on the spot by selling the stock away at $55 and book in the loses of $5000 ($60,000 – $55,000) into your account. A disaster, isn’t it?

Avoiding mistakes and always keep in mind the factors that will make us lose money will increase the chances of our success in trading and investing! Cheers!